Inflation Protection: I Savings Bonds

I Savings Bonds are a vehicle for protecting fixed-income investments against inflation.

I Bonds are accrual securities, which means that you do not receive interest payments (coupon income) until you redeem the bonds. But taxes on interest can be deferred until the bonds are redeemed or until maturity-that is, for up to 30 years. In addition, interest income is exempt from state and local taxes.

The earnings rate of I Bonds is a combination of two separate rates: a fixed rate of return, and a variable semiannual inflation rate. The fixed rate is set when the bonds are initially sold, and it remains the same throughout the life of the bond. But the semiannual inflation rate adjustment is reset every six months, based on the CPI-U.

In the unlikely event that deflation were to occur, the value of the bond would remain at its pre-deflation level. The combined rate does not simply add the two rates: They are combined according to a complex formula explained on the Treasury's Web site.

I Bonds have several major advantages:

The value of the I Bonds rises at the rate of inflation.

Furthermore, the interest rate set at the time of issue guarantees a minimum return.

Most importantly, however, because I Savings Bonds do not trade in the secondary market, the value of I Bonds can never go down. The value of TIPS, on the other hand, fluctuates in the secondary market and could conceivably decline below the issue price.

I Bonds can be bought directly through the Internet at the Treasury Web site, at a local bank, or through an employer-sponsored plan such as EasySaver. I Bonds are sold for face amounts ranging from $25 (online) to $5,000. They are purchased at face value: You pay $50 for a $50 bond. You can buy up to $5,000 worth of I Bonds each calendar year.

I Bonds have a maturity of 30 years, but they can be redeemed any time after 12 months. Because these bonds are structured primarily as long-term investments, there is a small penalty for redeeming I Bonds within five years of purchase: You would forfeit three months of interest if you cash out your bonds within five years.

Since no taxes are payable until the bonds are actually cashed in, they are extremely attractive for building up savings for retirement outside of tax-deferred accounts. Their education exclusion also offers an attractive method of saving for future college expenses.

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